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January 13, 2008

The US Economy and Bernanke's Economics
by Gerard Jackson

At the beginning of the month the Fed sent out a press release in which it brought attention to "a string of large current account deficits" by the US. We also had Mr Bernanke grandly declaring:

We stand ready to take substantive additional actions as needed to support growth and to provide adequate insurance against downside risks.

This brings me back to another Bernanke moment -- back in March 2005 -- when he argued that the US current account deficit was being driven by a net inflow of capital from the rest of the world. According to Bernanke's analysis

...a combination of diverse forces has created a significant increase in the global supply of saving -- a global saving glut.

Therefore "the savings excess" explained why the US current account deficit continued to grow even though interest rates remained low. The economic opinion of Daniel T. Griswold, associate director of the Center for Trade Policy Studies at the Cato Institute, bore a striking similarity to Bernanke's view that the current account deficit was mainly due to foreign savings flooding into the US because of its "stable and relatively free domestic market".

These arguments are superficial and very wrong and very dangerous. The idea that a nation can suffer from excess savings -- which is really the old surplus capital fallacy -- goes back to at least Jeremy Bentham. Fortunately, and with the use of Say's Law, James Stuart Mill successfully explained to Bentham why any notion of surplus capital was fallacious. However, in 1829 Edward Gibbon Wakefield published his Letter from Sydney. (Actually it was from an English prison where he was being held for abducing a young heiress. Who said economics was dull?) Part of Wakefield's thesis was that the colonies were needed to absorb England's surplus capital.

Fast-forward to 2005 and we find the US economy supposedly playing the role of a colony to the rest of the world's England. It's all nonsense. To say that a country can have too much savings is to argue that it can accumulate too much capital. But a country can never have enough capital. Investment exceeds savings when the central bank runs a loose monetary policy. In other words, the real name for "excess savings" is inflation

This subject was debated in much detail during the bullion debate in England that started more than 200 years ago. Because of the Napoleonic War the British government suspended gold payments in 1797. This giving the Bank of England carte blanche to inflate the note issue. In 1801 Walter Boyd published his Letter to Pitt in which he stressed

that the amount of Bank-notes in circulation, on the 6th of December, 1800, was £15,450,970!, which exceeds the sum in circulation on the 26th February, 1797, (viz. £8,640,250!) by nearly four-fifths of that circulation. (A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities, 2nd edition, T. Gillet, London, 1801, p. iii).

The premium on Bullion, the low rate of Exchange, and the high prices of commodities in general, I have mentioned as symptoms and effects of the superabundance of paper. (Ibid. p. xxxi).

Boyd argued that the banks had inflated the money supply because they had been freed by a government act from having to pay their depositors in gold. His criticism provoked a vigorous response, particularly from friends of the Bank of England. But Boyd's point was well made by the inescapable fact that between 1797 and 1800 the Bank of England had nearly doubled its note issue. Moreover, those notes were then used by the country banks to multiply their own bank deposits.

Walter Boyd, Lord Peter King, David Ricardo and their supporters became known as bullionists. (Irrespective of views to the contrary, Henry Thornton was not a complete bullionist). Ultimately their thesis that it was inflation that caused the gold drain and drove down the pound became generally accepted. Hence Thornton explained that

[t]he fall of our exchange will, therefore, promote exportation and encourage importation. It will, in a great degree, prevent the high price of goods in Great Britain from producing that unfavourable balance of trade, which, for the sake of illustrating the subject was supposed to exist. (Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great. Britain, London: George Allen and Unwin, 1939, p. 199).

Lord King demolished the concept of neutral money with the insight that new money enters the economy at different points bestowing its benefits on those who first receive it. It would have been one short step from King's insight to see that monetary expansion creates malinvestments, disproportionalities as the classical economists called them. King's analysis was directly along the lines of Richard Cantillon's observations which were laid out in his Essay on the Nature of Commerce in General (Transaction Publishers, New Brunswick [U.S.A.] and London [U.K] 2001, first published c1730).

Henry Thornton also understood that money was not neutral and therefore expanding the money supply by forcing down the rate of interest would distort the structure of relative prices and perhaps give rise to the phenomenon of forced saving. (Ibid. pp. 194, 243. p. 239 respectively). From this all too brief overview of the bullion debate we can draw the conclusion that the Fed's loose monetary policy is responsible for America's current account problems and falling dollar.

In defence of the Fed it can be argued that from America's foundation to 1870 investment exceeded domestic saving even though the country was on a gold standard for most of that period. This criticism would be based on a misconception about the nature of savings. It is customary to define savings as deferred consumption. It is true that when we save we defer consumption. However, to save means more than this: it means to transform present goods into future goods (capital goods). Therefore savings is a process that eventually brings forth a greater flow of consumer goods.

This definition explains why investment did not exceed savings in nineteenth century America, except on those occasions when the banking system deviated from the gold standard by rapidly expanding credit. When British savers invested in America they diverted factors from the production of goods in Britain to the production of future goods for the US economy. This analysis fingers the Fed as the guilty party.

If the rest of the world were on a gold standard the problem would have quickly become self-evident. However, two principal factors have obfuscated the process. Because other countries are also operating on a pure paper standard we find ourselves in a world of continuously changing money stocks. This means that currencies are forever moving against each other, and always in a downwards direction. The other factor is that these changing money stocks create uncertainty causing capital to seek out apparently safer havens. The effect of this process is to over-value a favoured currency. In my opinion, this is what happened to the US dollar.

The problem is not entirely Keynesian. Other economic fallacies that central bankers have swallowed are also at work. Meanwhile, the rest of us can only sit back and watch with increasing foreboding.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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